CFDs seem to be all the rage in the trading community these days. They’re not exactly the new kid on the block, but thanks to a certain air of mystery (courtesy of US regulators) and more than a whiff of danger (via European regulators) CFDs are on a lot of traders’ minds.
Let’s get to the bottom of one of the most risky but potentially rewarding financial instruments on the market today.
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What Does CFD Stand For?
The acronym CFD is short for “contract for difference.” What does that mean, exactly? A CFD is a contract between two parties stipulating that one will pay the other the difference in the price of an underlying asset from the moment the CFD was purchased to when it is sold.
How Do CFDs Work?
A CFD is a type of derivative, meaning that the value of a CFD is based on the value of another asset. With CFDs, traders can bet on price movements of any number of underlying assets without actually owning those assets.
For instance, if you think Amazon stock is going to go up, you could, of course, simply buy shares of Amazon stock (AMZN). You could also buy a CFD that is based on the price movement of the Amazon stock. If Amazon’s stock price goes up, your CFD will be more valuable, and you will still be making money without ever owning Amazon stock.
What Types of CFDs Are There?
As I just alluded to in the advantages section, there are CFDs for just about any financial market you can think of, and brokers are constantly adding to their CFD offerings.
Here’s the list of the most popular assets you can trade with CFDs:
Index CFDs are a great way to access global financial markets. Typical brokers offer CFDs for several US indices, including, of course, the Dow and S&P 500, plus the NASDAQ 100, and a few others. You can also easily find index CFDs for major European markets, such as the IBEX 35 (Spain), DAX (Germany), and the FTSE 100 (UK), as well as indices that cover the overall European markets. Indices covering the markets in Japan, Hong Kong, and Singapore are also commonly offered.
A really interesting class of index CFDs has emerged in the last few years centered around “thematic indices.” Thematic indices are made up of stocks grouped together by a particular theme or trend. A prime example is a green index, which groups together a number of companies that are leaders in green technologies. Other examples of thematic indices for which there are CFDs are cannabis, remote economy, Corona anti-virus, and a cryptocurrency index.
Forex pairs have long been among the most popular CFDs. You can’t access as many pairs through CFD trading as you can if you are simply trading through the forex market, but there are still a number of options beyond just the major currency pairs.
You won’t find CFDs for any obscure penny stocks, but there are still plenty of options for trading CFDs based on shares. The number of available stock CFDs varies widely from broker to broker. Some only offer a few CFDs for American blue-chip stocks, but others, such as Ava Trade, offer more than 700 options from markets all over the world.
As I’m writing this, the crypto world is in disarray. Bitcoin has lost more than half of its value, and other cryptocurrencies have suffered a fate even worse. It might seem, therefore, that this is a bad time to trade crypto CFDs, but this is where the ability to easily take short positions is such a big advantage. Anyone who sold crypto CFDs at their height and closed their position at the nadir is currently wondering how many yachts are too many.
Not all CFD brokers offer crypto CFDs, but you can still access the crypto market by trading crypto index CFDs or crypto ETF CFDs.
In a lot of ways, commodities may seem like the exact opposite of crypto, but there are CFDs for commodity markets as well. A lot of traders use futures contracts to access commodity markets, but CFDs are much simpler. Almost all CFD brokers offer CFDs for gold, oil and natural gas
Exchange traded funds, or ETFs, are basically mutual funds that trade like stocks. Some ETFs act like indices and track the S&P 500 or other indices, but there are also ETFs that have a more narrow scope, allowing you to trade different sectors, such as the energy or financial sector, or different market segments, such as emerging markets. There aren’t a whole lot of ETF CFDs currently offered, but they’re becoming more and more popular and I expect we’ll see a lot more options in the future.
What Are the Costs of CFD Trading?
One of the reasons we are hearing so much about CFDs lately is that CFD providers are really pushing them. Why? Well, like with most derivatives, brokers make much more money selling them then they do just selling the underlying asset.
Back to my AMZN example, a broker makes far less commission on a simple shares transaction than they would if you were to purchase an Amazon CFD. So, obviously, brokers push the CFDs instead.
Brokers make the most of their CFD profits in three ways:
This is where most CFD brokers make the bulk of their money. They sell CFDs at one price and buy them at another, keeping the difference. That difference is known as the spread.
Spreads vary greatly from broker to broker and are also dependent on the underlying asset. This extreme variance makes it tough to generalize how much CFDs spread, but the spreads at IG, which happens to be my favorite forex broker, are pretty representative. IG’s spreads start at a minimum of 0.6 points for forex pairs, 0.4 for indices, and .3 for commodities.
The tricky thing about spreads is that they aren’t constant. Spreads can vary widely during times of high market volatility. For instance, spreads for forex pairs will be higher around the release of key economic data.
Forex broker Oanda has a great charting tool that demonstrates how spreads change and react to different market conditions. Use the “Asset Class” drop down menu to select CFDs and you can see Oanda’s historical spread data and how its spreads have reacted to changes in the market.
A lot of CFD brokers don’t charge commissions at all, but some brokers charge commissions on CFDs covering shares. In these circumstances, your total trading costs are the commission plus the spread, although spreads are usually very small when a commission is charged.
Commissions can be either a flat fee or a very low percentage of the total value of the trade.
If you have yet to sign up with a broker, make sure you understand their fee structure for whichever CFDs you plan to trade.
Swap (rollover fees)
Brokers charge swap, also known as rollover fees, when traders leave a CFD contract open overnight. Since CFDs are highly leveraged, traders are essentially borrowing money when they purchase them. If you hold onto a CFD position for longer than a trading day, the broker will charge a certain level of interest for this “loan.”
Rollover fees vary by the size of your position and which type of CFD you’re trading, but if you do plan on holding CFDs overnight, make sure you know how much you’ll be charged.
A lot of brokers offer swap-free accounts for traders who are prohibited from charging or paying interest due to religious reasons.
What Are the Advantages of Trading CFDs?
So why mess around with CFDs when you could just buy the asset itself? There are a number of reasons to go the CFD route, but the most obvious is that CFDs give you substantial leverage.
CFDs are a leveraged product. Trading a leveraged product allows you to drastically increase your buying power because you’re only putting down a small percentage (known as the margin rate) of the capital that would otherwise be required. In other words, you can take large positions without putting too much money down.
Forex CFDs, for example, often have a margin rate of 0.5%. That means you could take a $200,000 position on a currency with only a $1,000 investment. Obviously that can lead to enormous profits if you make the right bet, but if the market moves against you, you could be on the hook for well more than your original $1,000. Leverage can drastically magnify both gains and losses.
Ability to maximize profits (CFDs vs stocks)
Traders use leveraged products with the hopes of maximizing profits, so let’s see how CFDs achieve that goal by comparing their performance to that of stocks.
Let’s say AMZN is trading at exactly $100 and (for simplicity’s sake) we live in a world without spreads or commissions. If you want to invest $1,000, you can purchase 10 shares at $100 each. If the stock goes up to $110, you would profit $100. Not bad.
Let’s go through that scenario and buy AMZN CFDs instead. We’ll set the margin rate at 10%, which is the current rate charged by IG, the world’s #1 (by their own metrics) CFD provider.
Thanks to the low 10% margin rate, your $1,000 can buy 100 CFDs, which are worth a total of $10,000. If the stock goes up to $110, you have 100 CFDs that are now worth $11,000. Your profits are $1,000.
Behold the power of leverage! Thanks to the CFD’s leverage, you achieved 10x the return on the same monetary investment.
Of course, trades don’t always go your way, so please also read the “Disadvantages of CFDs” section to see an example of a CFD trade that goes against you.
Ability to take short positions
CFDs make it very simple to bet that an underlying asset will decrease in value. Depending on the asset you want to short, it can be a complicated process in which you actually have to borrow the asset in order to short it.
With CFDs, you simply sell the CFD and buy it back when you want to unwind your position. Since CFD traders never own any actual assets, the process is exceedingly simple, and you can take advantage of rising or falling prices.
Hedging with CFDs
If you’re long on a stock because you believe in its long-term prospects but foresee some short-term volatility, CFD trading can be part of a simple and effective hedging strategy. You can sell CFDs and take a short position for that stock to profit off any short-term price dips, but still maintain your long-term position.
Access to multiple financial markets
Once you understand the ins and outs of this unique financial instrument, you can trade CFDs with a variety of underlying assets. Brokers offer CFDs for forex pairs, indices, shares, commodities, treasuries, and even crypto.
If you find a CFD broker you trust, you have access to global financial markets and any number of different underlying assets all from the same trading platform.
What Are the Disadvantages of CFD Trading?
Risk. CFD trading is an extremely risky pursuit for retail clients. I go into it a little more in the next section, but the bottom line is that more than two-thirds of all retail traders lose money when trading CFDs.
Magnification of losses (CFDs vs shares example)
In the advantages section, I showed you how CFDs can significantly magnify profits. This is the main draw of CFDs. However, let’s look at how they also magnify losses. Here’s an example of a CFD trade that goes against you.
Going back to the Amazon example, let’s once again assume you have $1,000 to invest and again, for simplicity’s sake we will ignore spreads and commissions. AMZN is trading at $100 and there’s a 10% margin rate. You’re bullish on Amazon and want to take a long position. That means you can buy 100 CFDs with your $1,000. So you’re buying 100 CFDs for $100 and opening up a $10,000 position.
Unfortunately, Jeff Bezos’ latest space expedition goes awry and Amazon’s stock drops 20 points in the blink of an eye. You now have 100 CFDs that are worth only $80 a piece, meaning your position has dropped to $8000.
Since you opened your position on margin with only $1,000, you’ve now lost twice as much money as you had. Your account would be at –$1,000 and your broker will come looking for that money you owe.
There are tools to prevent such extreme losses, like stop-loss orders, which would automatically close your position once your trade has lost a certain amount of money, and some CFD brokers offer negative balance protection, which would close your account the minute your $1,000 deposit was gone. The point remains, however, that any time leverage is involved, losses can mount quickly and wipe away more than your initial investment.
If you had just purchased $1,000 worth of AMZN stock, you would have purchased 10 shares. After a 20 point drop, you would have lost only $200 and lived to trade another day.
CFDs are considered so risky that they are prohibited in the US, Hong Kong, and Brazil, and many other jurisdictions have placed various restrictions on them.
Some examples of local laws, most of which are applied by other countries as well:
- In much of the EU, brokers must offer negative balance protection.
- In the UK, brokers are limited in how much leverage they can offer on CFD trades.
- In Canada, brokers must evaluate a client’s investment knowledge before allowing them to purchase CFDs.
- In Australia, margin is limited and brokers must issue product disclosure statements.
In many parts of the world, CFD trading is heavily regulated, so you have to see if they still make sense for you. If you’re interested in CFDs strictly because of the leverage, for instance, make sure that you know the regulations governing margin in your country.
CFDs are typically pretty cheap, but in times of high volatility, spreads can widen significantly. That means the sell price will be substantially higher than the buy price. If you’re trying to buy in or unwind a position during rocky markets, the wide spreads can take a big chunk out of your profits or really exacerbate losses.
In more traditional markets, you buy an asset, such as shares from another trader, through an exchange. Exchanges are highly regulated and insured, and there is very little, if any, counterparty risk.
With CFDs, however, you’re trading contracts over the counter with your CFD broker. Since the counterparty is the broker without any intermediary, you run the risk, however slight, of your broker going bankrupt without honoring the contract.
Large brokers don’t frequently go bankrupt, but it does happen. In 2011 MF Global, primarily known as a futures broker but also a CFD provider, went bankrupt. They lost billions of dollars of clients’ money in the process, and although most client funds were eventually refunded through bankruptcy proceedings, it took years.
Are CFDs Risky?
Yes. CFDs are highly leveraged derivatives, meaning that they are complex financial instruments that can significantly magnify losses (as well as gains). The vast majority of those trading CFDs lose money.
CFDs are so risky, in fact, that they are prohibited for American traders, and brokers that offer CFDs in other jurisdictions are often forced to include the following disclaimer: CFDs are complex instruments and come with a high risk of losing money rapidly due to leverage.
Many brokers are also required to publish what percentage of their retail investor accounts lose money. These figures vary from broker to broker, but when I compiled a list of statistics from 15 different CFD brokers, the lowest percentage of retail investors who failed was 67%. That’s right, even at the broker that fared the best, two-thirds of those who opened a CFD trading account lost money.
Can Americans Trade CFDs?
Not legally. CFDs are banned under an amendment to the Commodity Exchange Act, which states that “US retail persons are prohibited from entering such swaps unless they are offered on a designated exchange.”
Some brokers pushed back, arguing that CFDs were not technically “swaps” but the CFTC definitively included CFDs in this category in 2012. This classification means that CFDs are only allowed if they are traded on a regulated exchange, which they are not.
Why can’t Americans trade CFDs?
US regulators main issue with CFDs is the fact that they are not traded through a regulated exchange. Theoretically, if the Chicago Board of Trade or another regulated exchange began to offer CFDs, they could be legal in the US. Since all CFDs are currently offered over the counter, however, the CFTC views them as unregulated derivatives, which are prohibited.
US regulators don’t allow OTC derivatives for a number of reasons. One factor is they want to protect retail investors from murky, risky financial instruments, but OTC derivatives also make it very easy to skirt insider trading laws. For example, an Amazon executive is prohibited from buying AMZN stock without disclosing their purchase to the SEC, but they could easily buy Amazon CFDs from an offshore broker and profit from insider information.
It’s unlikely that a regulated US exchange will begin offering CFDs anytime soon. The Australian Stock Exchange (ASX) offered CFDs for a few years, but it didn’t go well. Regulation always adds costs, and most traders were content to save money trading their CFDs over the counter. The ASX CFDs therefore suffered from low volume and a lack of liquidity.
That said, CFD brokers are making so much money that I wouldn’t be surprised if someone finds a way to bring them back to US traders.
Conclusion: What are CFDs?
CFDs are, as the kids would say, “having a moment.” They’re everywhere. But don’t mistake their ubiquity for safety. The risks of trading CFDs are significant, particularly for retail traders. More than two-thirds of all retail investor accounts lose money when trading CFDs.
A successful CFD trader is someone who thoroughly understands both the instrument and the underlying asset that they’re trading. I hope this CFD FAQ helps further your understanding. Please leave a comment below if you have any more questions, and I’ll answer them in short order.